Credit cards are a financial tool that sits in the middle of many people’s personal finances. They offer an opportunity to borrow money, earn rewards, build your credit, protect yourself from fraud, and much more.
When used irresponsibly, however, credit cards can lead to expensive mistakes, big interest costs, and bad credit.
Today we are going to take a look at a fundamental question in personal finance: How do credit cards work? We will look at the ins and outs of credit cards in this detailed guide for beginners and experienced credit card users alike. Don’t swipe until you read this!
How do credit cards work?
There are a lot of different credit cards out there, so to start we are going to look at some general information that applies to all credit cards.
Credit cards are a type of unsecured debt that allow you to spend money now and pay it back later. With a true credit card, you can carry a balance from month to month if you choose and make small payments until your card is paid off.
This is a contrast to a charge card, which requires you to pay the balance in full each month. But even if you have a regular credit card, paying the balance in full every month saves you a lot of money in interest. More on that in a moment.
What is most important to understand is that credit cards let you borrow money that you have to pay back. And while it is not attached to an asset, unlike a car loan or a mortgage, you will incur financial penalties and higher costs if you don’t use your card responsibly and make timely payments.
Credit card interest 101
Credit cards charge cardholders through two primary methods: fees and interest. We’ll get into fees later on. For this section, the focus is on how credit card interest works.
Credit card interest is a charge for borrowing money from the credit card issuer. While a credit card doesn’t feel like other loans, in many ways it is. After all, you are spending someone else’s money until you pay it back.
If you pay your balance back in full before your statement due date, you won’t have to pay a cent in interest. This is a huge concept, so we'll say it again: if you pay off your card in full every month, you don’t have to pay interest.
If you use your card and don’t pay off the full balance, you will find yourself with an interest charge. Interest rates are based on the card, your credit history, and market rates. Most cards charge interest somewhere between 8% and 30% APR.
When you look at credit cards, you’ll notice interest is always quoted in APR (annual percentage rate), while accounts that pay you are quoted in APY (annual percentage yield). APY includes compounding, which makes the number a little higher than APR.
Your credit card interest charge is based on the card’s daily rate and your account balance. If you have a card that charges 20% interest and you end June with a $1,000 balance, your interest charge would work as follows:
20% interest rate / 365 = .0005479 daily interest rate
30 days in June x .05479 daily interest rate = .0164 monthly interest rate
$1,000 balance x .0164 monthly interest rate = $16.44 interest due
But if you just paid that $1,000 before the due date, interest due is $0! Replace the interest rate, number of days in the month, and your balance to calculate your own potential interest due for your credit card.
Intro to credit card rewards
Now that you know the big way credit cards cost you money, let’s look at ways credit cards can make you money. Every time you use your credit card, you may be able to earn credit card rewards.
Credit card rewards typically come in the form of cash back, travel miles, or points. Travel rewards and cash back rewards are the two biggest categories of rewards credit cards.
Every time you use your credit card for a purchase, the credit card networks charge the merchant a fee. Depending on the merchant agreement, this is usually around 2% to 3% of the total transaction. If you go to the store and spend $100, the store will pay around $2 to $3 in fees.
These fees make banks and credit card issuers a ton of money, so they want you to use your credit card as much as possible. One way they incentivize us to use our cards more is giving us a share of those fees in the form of rewards.
Credit card rewards can be so valuable that they offset the annual fees charged by some cards. In addition, new cardholders can often qualify for a signup bonus on rewards credit cards that can be worth thousands of dollars.
Cash back rewards typically offer a clear value in return for each dollar you spend. For instance, if you spend $100 on a card that gives you 2% cash back, you’ll end up with $2 in rewards. With a miles and points card, the value is not so simple.
With a card that offers travel or general point rewards, you may find a value of less than one cent per point or a value of more than one cent per point depending on how you use your points. As a general rule, when used well, miles and points are more valuable than cash back.
But the rewards you earn are only valuable if they are valuable to you. Choose the right type of credit card for your needs to maximize the value you get back from your card.
Types of credit cards
There are many ways to slice and dice credit cards into categories. To get a general understanding, we are going to look at some of the most common types of credit cards, how they work, and some pros and cons to consider when deciding on a new card for your purse or wallet.
Low-interest credit cards
The first type of credit card we are going to discuss today is the low-interest credit card. An example of this is Chase Slate, which charges a relatively low APR compared to many others in the industry, including rewards cards.
Most low-interest credit cards do not come with strong rewards program. Chase Slate offers low interest, but no rewards at all. Other cards in this category follow similar patterns.
Because card issuers don’t make as much money from low-interest cards, they are not as easy to find. Also, to get the best interest rates you will need a good to excellent credit score.
Cash back rewards credit cards
Cash back rewards cards pay you cash back every time you use the card to make a purchase. Popular examples include Chase Freedom, Chase Freedom Unlimited, and Citi Double Cash.
With flat rate cash back cards, you will earn the same cashback rate regardless of where you use your card. Some cards offer higher reward rates for bonus categories. For example, the Costco Visa offers 4% back on gas purchases up to $7,000 per year.
Some cards use more complex rewards systems. If you follow along, you can sometimes get much bigger rewards from these cards. Chase Freedom offers 5% back on categories that rotate every three months. If you can cash in big on the 5% bonus categories, your cash back adds up fast.
Travel rewards credit cards
Travel rewards credit cards are great for anyone who loves jetting off across the world to exotic destinations, anyone who has family spread out around the country and wants to make regular visits, or anyone that falls somewhere in between.
Travel rewards cards offer miles or points for every dollar you spend. Some cards offer 1 point per dollar, while others offer bonuses similar to cash back cards. For example, with the Chase Sapphire Preferred card you get 2x points for every dollar you spend at restaurants or on travel purchases.
Some travel rewards cards are branded to a specific airline or hotel, like the Marriott rewards card and United Explorer card. With these cards, you earn Marriott rewards points and United miles respectively, plus extra perks and bonuses like upgraded status and free checked bags.
General points cards give you more flexibility in how you use your points. Chase Ultimate Rewards cards, like the previously mentioned Sapphire Preferred and, the coveted American Express Platinum card both fall into this category.
With a general travel points card, you can redeem for travel through the card issuer portal or transfer points to partner airlines and hotels for big value reward redemptions. Just be aware your flights won't be entirely free, as you'll still be on the hook for TSA fees of about $5.60 per domestic flight (probably closer to $100 per flight for international flights). But, given the savings, we're sure you can live with that.
The best travel rewards cards tend to offer big signup bonuses. For example, if you can get a 100,000-point signup bonus on the American Express Platinum card, you have enough miles for two coach round-trip flights to Europe worth thousands of dollars.
Balance transfer credit cards
Balance transfer credit cards allow you to transfer your balance from one card to another, ideally at a lower interest rate. This helps you simplify your payments, save money, and hopefully get out of credit card debt for good.
Most balance transfer cards offer a 0% APR introductory period that is great for chipping away at big credit card balances. Chase Slate, mentioned above, is a great credit card for balance transfers. Another good choice is Ring from Barclays.
Just beware of a few possible mistakes when doing a balance transfer. First, only transfer to a card with a lower interest rate in the long run. You don’t want to move your balance to a card to get 0% APR for a short period before it skyrockets to a higher rate than you paid before!
Next, look out for balance transfer fees. While Barclay Ring does not charge a balance transfer fee, many cards charge around 3% of the total balance transferred in fees.
If you do have to pay a fee, it could be worth it in the long-run if it leads to interest rate savings. If you move a large balance to a 0% APR card, you could easily make up the cost of the transfer fees in two to three months.
Store credit cards
Some stores offer their own store credit card. Popular examples are the Kohl’s card and Target REDcard. But don’t rush to sign up.
Most store cards come in two versions. The first is a store-only version that only works at the issuing store. These often come with discounts for regular shoppers, but the cards usually come with terrible interest rates and hurt your credit.
Some stores also offer a card branded with a Visa, Mastercard, or other logo. These can be used anywhere and don’t have the same negative aspects as many store-only cards.
But in general, unless you shop at one store so much that the card would offer you huge savings that are bigger than any cash back or travel rewards card, you should skip the store cards. You can do better.
Credit cards and your credit report
Credit cards do not work in a vacuum. They have far-reaching effects on much of your personal finances. In addition to the interest charges you may incur, credit cards have a big impact on your credit report and credit score.
Your credit report is a listing of all of your credit account activity for the last seven to ten years. That includes every payment, balance, collection, bankruptcy, and judgment for that period of time.
Your credit report is maintained by three big credit reporting bureaus: Equifax, Experian, and TransUnion. They use your credit report data to calculate your credit score.
Your credit score is a number between 300 and 850 that tells banks and other lenders how likely you are to repay a loan. A high credit score helps you get better credit cards and lower interest rates, where a low credit score can lead to credit application denials and higher costs.
To keep a high credit score, always pay off every credit account on-time every month. A late payment stays on your credit report for seven years. While it takes years to build perfect credit, a string of a few late payments is all it takes to turn a good credit score into a bad one.
In addition to late payments, high credit card balances also harm your credit score. One of the fastest ways to fix a bad credit score is paying off credit card debt. While it is easier said than done for many people, a $0 credit card balance is the best balance for your credit score.
How credit card fees work
One last important topic before we end this guide: credit card fees. Credit cards may charge a range of fees for specific activity. You can avoid most credit card fees by avoiding those activities, though not all fees are avoidable or terrible.
Common activity-based fees include balance transfer fees and cash advance fees. By skipping out on cash advances and balance transfers, you can easily avoid these fees. Also, remember that cash advances often require higher interest rates, so proceed with extreme caution. Balance transfer fees are usually around 3% and cash advance fees are usually around 5%.
Some cards charge a foreign transaction fee when you use your card outside of the United States, but the best travel cards don’t have this cost. Foreign transaction fees, when applicable, are usually around 3% of the transaction value.
Some credit cards charge annual fees. If you don’t use a card with an annual fee, you should downgrade to a card with no fee or close it. But many cards offer huge value that far exceeds the annual fee.
For example, it's possible (and relatively easy) to earn over $200 in value back from the Chase Sapphire Preferred card, making the $95 annual fee completely worth the cost. Compare your benefits to the fee to decide if an annual fee makes sense for you.
Credit cards are a great financial tool
Now you know the answer: how do credit cards work? They are a great and important financial tool, but only when used responsibly and appropriately. There are too many bad credit card horror stories to go in with your eyes closed, so make sure you understand how your credit card works before you start shopping around town.
But when used responsibly, credit cards can give back to you big time for every dollar you spend, and some you don’t. By taking full advantage of credit card rewards, you can get your credit card to pay you! To responsible credit card users, that is what credit cards are all about.
Editorial Note: This content is not provided or commissioned by the credit card issuer. Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by the credit card issuer. This site may be compensated through a credit card issuer partnership.
This article was last updated July 3, 2018 but some terms and conditions may have changed or are no longer available. For the most accurate and up to date information please consult the terms and conditions found on the issuer website.